Will Angela Merkel Save Europe’s Banks?

June 28 (Bloomberg) -- Europe’s leaders have raised hopes
that, when they meet Thursday and Friday in Brussels, they will
agree on a banking union aimed at severing the link between the
health of the euro area’s financial institutions and the
solvency of its governments.

The plan’s success or failure, as with so much else in the
currency union today, will depend on one person: German
Chancellor Angela Merkel.

The euro area’s banking system has long suffered from a
fundamental imbalance. Most countries have large banks whose
failure would have repercussions for the entire currency union,
yet the responsibility for overseeing the banks, guaranteeing
their deposits and bailing them out falls on national
governments. The burden can be unbearable given the size of
banking assets in some countries -- about two times gross
domestic product in Germany, and three times in France and
Spain.

The current crisis has made the pitfalls painfully evident.
Spain’s borrowing costs are soaring, with the 10-year bond yield
approaching 7 percent, as investors worry that the government
can’t afford the 100 billion euros or more needed to shore up
its banks. Depositors are fleeing Greece, Italy, Portugal and
Spain amid concern that governments can’t or won’t guarantee
repayment in euros. Regulators are afraid to run credible stress
tests because it’s not clear how the capital needs they identify
would be addressed.

Quid Pro Quo

The solution -- laid out this week in a proposal by
European Union President Herman Van Rompuy -- involves requiring
euro-area members to give up some sovereignty in return for
centralized support. A European entity, probably the European
Central Bank, would take over the power to supervise all banks
in the union, possibly with the help of national regulators. A
separate entity would gain the authority to dismantle banks
forcibly when they get into serious trouble. The quid pro quo
would be a collective promise, backed by all euro-area
governments, to insure deposits and recapitalize banks anywhere
in the union.

Speed is crucial. With each passing day, the paralysis of
the euro area’s financial sector is taking a toll on Europe’s
most vulnerable economies, further worsening the plight of both
the banks and the governments. At some point, high borrowing
costs and shrinking output will render large governments such as
Italy and Spain insolvent. If an agreement in principle on
banking union could be reached quickly, Europe could move ahead
with the kind of stress tests needed to draw a line under banks’
losses, recapitalize and move on.

Problem is, Merkel agrees to only the supervisory part of
the banking plan. She rejects any form of risk-sharing, be it
collective euro-area backing for banks and their depositors,
joint euro bonds, fiscal transfers or direct ECB debt purchases
that would reduce the borrowing costs of struggling governments.
“I’m concerned that once again the discussion will be far too
much about all kinds of ideas for joint liability and far too
little about improved oversight,” she said at a conference this
week.

There are ways to mitigate Merkel’s concerns. Imposing
losses on the creditors of troubled banks, making banks pay for
deposit insurance and requiring national governments to
contribute to any recapitalizations can all reduce perverse
incentives and lessen the likelihood that euro-area members will
have to pay for one another’s bailouts. We hope some compromise
can be reached.

Ultimately, the question of joint liability is a political
one that goes far beyond banking. No currency union consisting
of economies and cultures as different as, say, Germany and
Spain can work unless its members agree to share the risks of
financial and economic shocks. Refusing to do so is tantamount
to rejecting the euro.

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